"Bonds bring balance to a portfolio and add protection against market volatility. They also provide predicable solid returns for investors. [These] are a few of the reasons that young investors should add bonds to their investment portfolios."

Okay, so maybe we should consider bonds. As investors the first thing we usually examine is the historical track record of a new investment. Looking at any bond investment for the past 5, 10, 20 or even 30 years shows dramatic gains in value as interest rates have steadily declined. But is that past performance history useful?

Tadas Viskanta Mauboussin, founder and Editor of Abnormal Returns, highlights the risk of depending on past performance, in this case the track record of bonds.

"That disclaimer, or some variation thereof, is a prominent part of any document related to the past performance of a money manager, mutual fund or managed account these days. This disclaimer is so common that is has become a cliché and no longer packs the impact that it probably should on prospective investors."

In the same post, Tadas quotes from a Jack Schwager book:"Market Sense and Nonsense: How Markets Work (and How They Don't)".

"Past returns are not future returns. Past returns can be very misleadingif there are reasons to believe that future market conditions are likely to be significantly differentfrom those that shaped past returns. [p. 315]" (emphasis added)

If the "Past Performance …" cliché is to ever have any meaning it must be applied to the expected future performance of bonds, bond funds and bond ETFs. Is there any sentient person who does not believe "future market conditions" for bonds will "be significantly different" from "past returns"? Why will it be different? Because since peaking in 1981 at nearly 14% (basis 10 year Treasury Notes) interest rates have been on a steady decline to less than 2% today. Which means the price of a bond has been on a steady rise for more than 30 years. It has been a massive, unprecedented, bull market in bonds. But with interest rates at historic lows this cannot possibly be repeated. Thus we must ignore the past performance of bonds and look only to future market conditions.

As we look at probable future market conditions we can examine the relative merits of individual bonds versus bond funds or ETFs. Given that current interest rates are at historic lows the near term future is most likely one of rising interest rates with the most distant future that of significantly higher rates. Any rise in interest rates means the price or value of any bond investment will decline. How much? How high will rates go and how fast? Impossible to answer. This may seem an argument against bonds but equities will react to rising interest rates as well. There is no safe investment that generates a return.

What then do we make of the choice between individual bonds, bond funds or bond ETFs? For this question a bond mutual fund and bond ETF are so similar in function and performance as to constitute the same device. The mechanics of each are slightly different but little else. So, bonds or bond funds?

In a recent post retirement writer Paul Merriman discussed the pros and cons of various bond investment strategies in: 5 bond-fund strategies for retirement investors. As the title suggests he has a strong bias towards bond funds. In a comment I noted that his advice on bonds in portfolios was positive. However, I was critical about the use of bond funds versus individual bonds to fulfill a bond allocation strategy.

To be fair I also listened to Paul's podcast entitled, "Should I use bonds or bond funds?"Unfortunately the podcast was essentially a litany of support for bond funds. He mentioned only one individual bond advantage: a specific maturity date. To his credit Mr. Merriman is quite public and consistent in his preference towards bond funds for individual investors. On the other hand I have developed a decidedly negative view of the future value of bond funds versus individual bonds.

It is not reasonable to expect anyone to write a single article or book to cover every individual retiree situation. But it is equally unreasonable to promote a generalized investment tactic that is highly likely to be detrimental in the future. I would contend that many advisors are falling prey to the "Past Performance …" cliché when they promote bond funds over individual bonds. Again, there is no disagreement on the value of including bonds in a retirement portfolio. But I do disagree on the manner, the tactic to be utilized when doing so.

In a post on the "Observations" blog the author asks if there is a "bond bubble"?. The ensuing discussion suggests the answer is a clear "yes". The author then describes a hypothetical case of bond fund price changes when interest rates rise.

In October 2010, the yield on 10-year Treasury Notes was 2.54%, not far off the 2.4% low set during the financial panic near the end of 2008. These are historically low rates. To find comparable rates, you have to go back more than 50 years, to 1954. Even in the pre-1960 world, these would be below average interest rates.

Because of the relationship between yield and bond price, near all-time low interest rates mean near all-time high bond prices. It's a near certainty that bond prices can only go down from here -- though it won't necessarily happen immediately. As a result, not only are investors in intermediate and long-term treasury bond funds less likely to continue to benefit from falling rates, they are likely to see price decreases when rates increase.

How much impact could that have? Just to make the point (i.e., this is a completely hypothetical example), consider if 10-year interest rates were to immediately increase from 2.5% to the "100-year" average rate of 4.9%; holders of new bonds would see a price decrease of almost 20%. An increase to the more recent average of 6.7% would translate into a price decrease of closer to 30%.

Yes, there is a "hidden risk in bond funds." As bond investors we seek interest rate returns with security of principal and reduced portfolio volatility. Yet in the 41 years beginning in 1963 interest rates rose from 4% up to almost 14% in 1981 and back down to 4% by 2003. A wild ride for bonds. What would have happened to an intermediate-term bond fund during that period?

For our purposes assume a hypothetical Treasury fund tracks the annual average 10-year Treasury Note yield. The initial investment is assumed to be $100,000. And each year the fund earns the average annual yield of the 10-Year Treasury Note. From 1963 through 1982 the bond fund would have had steadily increasing yields and would earn $148,146 in interest income or an average of $7407 per year. However, by the end of 1982 the principal value of the investment drops by half to $50,417.

On the other hand, an individual 10-year Treasury Note purchase in 1963 and again in 1973 would have achieved a somewhat different outcome. At the initial yield of just over 4% the first bond would have earned a total of $40,030 from 1963 to 1972. Reinvesting at the higher yields of 6.84% available in 1973 would have earned another $68,430 in interest over the second 10-year period. At the end of 1982 the bond matures and the holder would receive back their entire $100,000 investment. Over those 20 years total income would have been $108,460. Nearly $40,000 less than the bond fund but with 100% of principal being returned.

At this point interest rates have peaked and have already started to decline. In fact rates are just starting what turns out to be a decline of more than 30 years. Over the period from 1983 through 2003, the hypothetical Treasury fund earns an impressive $153,893 interest. At the same time the principal value of the fund rises almost all the way back to its original $100,000 level by year end. This is a terrific performance by any measure.

The individual bond investor again fares differently. Reinvesting in 1983 at yields exceeding 11% the investor earns a total of $111,050 over the 10 years ending 1992. Now reinvesting at the lower rate of 5.87% the earnings for the next 10 years will total $58,730. The return for the final year, 2003, is near the original 4% rate and earns a modest $4,015. The total income for the entire 21 years is $173,795. But that amount is $19,902 more than the total earnings from the bond fund. And the Treasury Note matured every 10 years and returned the full $100,000 principal every time.

There are two key points. First, clearly a bond fund does have certain advantages over individual bonds. But it is not a free lunch. Second, in some circumstances individual bonds can and do outperform equivalent bond funds. Most importantly investors must recognize the validity of the "Past Performance …" cliché. The impressive track records of bond funds are published and promoted widely. But they are in the context of a 30-year historic bull market in bonds. That will not, cannot be repeated going forward. Unless we also have another historic bear market in bonds first.

It can and will be argued that the principal loss in a bond fund will be felt in an individual bond at the same time. That is correct. What cannot be argued however, is that as long as the bond issuer does not go bankrupt the individual bond holder will receive their principal back when the bond matures. But since a bond fund never matures there can be no such promise for the bond fund investor. And that's the key point for the future of bond fund investors today. Given the current historical context of record low interest rates the most likely future path is for higher rates and lower principal values. Meaning that when a fund holder seeks to cash out their fund holdings the full principal value will not be available. As long as individual bond holders wait for their bond to mature they will receive their full principal in return.

One way to evaluate bonds versus bond funds has been to look at the historical period from 1963 through 1982 to examine the impact of rising interest rates. A more practical view might be to assume some amount of interest rate increases, less than the historical record, but sufficient to bring current interest rates back to historic averages within a reasonable time frame. For example, a 0.25% increase each year for the next 16 years would bring current 2% rates back to the historic 6% average. Were that to occur - and something will occur eventually - what would be the impact on bonds versus bond funds?

Such a relatively gentle rise in interest rates - and we assume the bond fund adjusts - in fact permits the bond fund to achieve yield gains over and above the principal loss. However, for investors to profit from the higher yield means they must set aside income gains sufficient to compensate for the principal loss. While perhaps personally difficult this is doable. The net result then is a gain from rising yields over principal loss. A lot of assumptions though: gentle and steady rise in rates; bond fund able to adjust quickly (immediately actually); investor able to set aside income gains.

Individual bond investors do not need any of those assumptions. They receive a stable, albeit low, income stream and are able to spend it as needed. At the maturity date all principal is recovered and may then be re-invested at the new higher interest rates. At that time - and if rates do not increase further - bond investors will earn equivalent incomes to bond fund investors. This is the best of all probable future scenarios for the bond investor.

In this simple example a $1000 investment in a rapidly adjusting bond fund paying an initial 2% interest, which rises 0.25% every year to 6% will earn a total of $660 in interest over the 16 years. However, this is partially offset by a principal loss of $279 over the same period for a net income of $381 per $1000 invested. The individual bond holder, after reinvestment at year 10, earns a net $510 over the same period with no principal loss. Advantage: individual bond earning $510 + 100% of principal versus bond fund earning $381 + 100% of principal.

If interest rates rise more dramatically however the difference is even more stark. Assume a moderate rate rise of 0.50% every year until rates hit 6%. Assume again that the bond fund can adjust so its yield rises accordingly. This by the way is a very generous assumption as fund yields rise only as quick as the fund managers are able to sell existing bonds and replace them with new, higher-yielding bonds. The loss on such sales is the basis for the fund investor's loss of principal. It takes only 8 years to rise to the 6% rate. In this new faster rate rise environment the fund investor suffers a principal loss of $260 (in 8 years not 16) but earns a total of $340 in interest income (all per $1000 invested).

In this faster rate rise scenario the bond fund investor earns a total of $340 in interest income but suffers that $260 loss of principal in the process. The net gain of income less principal loss over the 8 years is $80 per $1000 invested. By contrast the individual bond investor, receiving the low rate of 2.5% per year, only earns $200 but receives 100% of principal in two more years. The bond fund investor is not likely to do so. As before the advantage goes to the individual bond investor.

If rates stabilize at some new higher level the bond fund investor may eventually earn enough additional income to cover the principal loss and exceed the earnings of an individual bond. But that can take several years at best. At the same time the individual bond investor will be able to reinvest at those new higher rates and always recover their principal.

For retirees the issue should not be whether to include bonds or similar instruments in their portfolio but how best to do so. And that answer may also be pertinent to non-retirees who are still working, saving and building their retirement portfolios. When considering a fixed income investment today it must be recognized that the future will be distinctly different from the past. And far more hazardous. The key point is that when facing a rising interest rate scenario an investor does better in the future with individual bonds rather than with a bond fund.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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